Where do investors tend to put their money in a bear market?
A bear market is traditionally defined as a period of negative returns in the broader market to the magnitude of between 15-20%, or more. During this type of market, most stocks see their share prices fall, often substantially. There are several strategies investors employ when they believe that this market is about to occur or is occurring, and they typically depend on the investor's risk tolerance, investment time horizon and objectives.
A Conservative Strategy
One of the most conservative strategies, and the most extreme, is to sell all investments before the downturn begins or before it hits its lowest point, and either hold cash or invest the proceeds into much more stable financial instruments, such as short-term government bonds. By doing this, an investor can attempt to reduce his or her exposure to the stock market and minimize the effects of a bear market.
But this strategy requires knowing when to sell, and bear markets can be very difficult to predict. As Ryan Miyamoto, a CFP® in Pasadena, CA, explains, “Selling at a loss is your biggest threat. A bear market will test your emotions and patience…The best strategy to control your emotions is to have a game plan. Start by creating a safety net that is not invested in the market. Seeing your accounts go down will be a lot easier if you know you have adequate cash on hand.”
Paul R. Ruedi, a CFP® financial advisor in Champaign, IL, suggest investors regularly do “lifeboat drills” before a bear market starts. He says investors should “...imagine a bear market has occurred and the stock portion of their portfolio is down 20% or 30%. How will they feel? How are they going to react? Are they going to panic, or remind themselves that “this too shall pass,” and stay the course with their investments? We remind our clients to do these all the time, and when a bear market occurs, they are spared the panic and emotions that consume most investors during bear markets.”
A Defensive Strategy
For investors looking to maintain some positions in the stock market, a defensive strategy is usually taken. This type of strategy involves investing in larger companies with strong balance sheets and a long operational history, which are considered to be defensive stocks. The reason for this is that these larger, more stable companies tend to be less affected by an overall downturn in the economy or stock market, making their share prices less susceptible to a larger fall. With strong financial positions, including large cash holdings to meet ongoing operational expenses, these companies are more likely to survive downturns.
These also include companies that service the needs of businesses and consumers, such as food businesses (people still eat when the economy is in a downturn) and companies that sell basic consumer goods (people still need to buy toothpaste and toilet paper). In this same vein, it is the riskier companies, such as small growth companies, that are typically avoided because they are less likely to have the financial security that is required to survive downturns.
Bonds and Cash
As Benjamin Westerman, CPA/PFS, CFP® in St. Louis, MO explains, many investors look to bond holdings and cash during a market downturn. “Bonds are your 'sleep at night' money that is protected during a bear market, while you wait for your investment portfolio to recover. In addition, if you have any money on the sidelines or are still in the accumulation/savings phase of your life, this is a great opportunity to invest in equities while stocks are on sale.”
As investors will find, there is a wide range of other tactics that can be tailored to a bear market. The most important thing is to understand that a bear market is very difficult to predict, and to remember that most strategies can only limit the amount of downside exposure, not eliminate it entirely.
Some just buy treasury securities. That's known as a flight to quality, which typically happens on the way down.
Bear markets are driven by fear, so when stocks go into the tank investors may tend to sell, often far too late. This, of course, is illogical, because in most cases, when prices go down, it's a good time to buy. In the stock market, however, what's logical is a path that's rarely followed.
Bear markets don't announce themselves. They just happen. They begin with a sell-off when that most folks dismiss as a brief correction. As they deepen, the question then becomes how far down will it go. From my many decades of experience, it's been obvious that most investors are so shocked by what's going on that they do nothing. Or, at the point of greatest pain (the bottom), they sell. Very few have the fortitude to view the situation unemotionally and move their money to where the best opportunities are. During bear markets, the best opportunities are in stocks, since the sell-off has reduced values to much more attractive levels. But it's the rare investor who has the courage to buy in. Most are paralyzed by fear.
If we look back at the history of bear markets in the United States, then they were usually preceded by lengthy, strong bull markets. Those bull markets encouraged most investors to pile into the stock market and into high-yield corporate bonds, with the highest concentrations close to the tops. We can see that recently with all-time record inflows into U.S. equity funds--especially passive equity funds including ETFs--in 2017. Thus, as each bear market begins, people have huge percentages of their money in the stock market.
The bear market always proceeds in a manner which discourages investors from selling anywhere near the top. The biggest losses and the gloomiest media coverage occurs only at the end, encouraging investors to sell in disappointment just before each bear-market bottom. The biggest monthly outflow in U.S. history occurred in February 2009, just before one of the strongest and longest bull markets in history.
In this way the fewest people benefit from both bull and bear markets.
A more intelligent approach is to have assets like U.S. Treasuries during a bear market for U.S. equities. Some short positions in the most popular funds are more aggressive and also will usually be profitable. In the first year of a bear market for U.S. equities, commodity producers and emerging markets often outperform as they have already been doing since January 20, 2016 and which will likely continue through some point in 2018.
If you are still working, a bear market can be an opportunity to buy more stocks at cheaper prices. The best way to invest during bear markets is to put small amounts in every month. You invest a fixed amount, say $1,000, in the stock market every month regardless of how bleak the headlines are. The strategy is called dollar-cost averaging.
Investing every month doesn't work all the time especially if the market is in a long-term uptrend, it is best to have every dime invested as long as possible. But in bear markets regular monthly investing works.
Also investing in stocks that have value and that also pay dividends. Since dividends account for a big part of stock market gains then the bear markets would be shorter and less painful if dividends were included.
It is important to have a financial advisor to “hold your hand” during market downturns. An advisor can help you by preventing you from selling out at the wrong time based on your fear or emotion.
Additionally, having a diversified portfolio in stocks, bonds, cash, and alternative investments is important in a bear market. Alternative investments are non correlated with the stock and bond market so over time having this type of asset allocation has proven to out perform the older more traditional stock, bond and cash portfolio asset allocation model.
From a logical perspective the perils of attempting to exit the market before it goes down are well documented. However, when asked: What do investors collectively tend to do during a bear market? We see that they often react by pulling money out of the market and flee to shorter term fixed instruments such as money market funds or CD’s. According to the Investment Company Fact Book, during the 2008 downturn investors withdrew $211 billion from mutual funds, while money market funds saw a net increase of $637 billion.
Reacting during a bear market can often be detrimental to long-term portfolio growth, especially during periods like the relatively short 17-month bear market from October of 2007 to March of 2009.
Many retail investors will actually stay put because they have been told "you can't time the market." Many will finally say Uncle when they reach their pain threshold. Every bear market is slightly different. In 2008, the place to be was treasury bonds, gold, cash, and shorts using inverse exchange traded funds (ETFs) betting the market will go down.
But if you rely on some type of technical indicators, cash is the most conservative, simply covering up until the dust settles. Investment grade bonds and treasuries historically have been a safe haven. But with interest rates likely on the rise, it won't be so certain this time and the bubble may actually be in bonds. They are currently already off between -5% to -7% depending upon the bond sector. But using short selling ETFs are a simple, elegant way to either make money or simply hedge your long positions you don't want to sell. This can also be owned inside an IRA or retirement account whereas shorting individual stocks cannot. You also don't have to worry about margin interest or margin calls.
I personally will use a combination of cash, short term bonds, and short selling ETFs. I will also consider gold depending upon how it is acting at the time.
Hope this helps. Happy Holidays, Dan Stewart CFA®